COVID-19 is putting strain on the construction industry and its supply chains globally. Given the importance of cash flow in the construction industry, such strains often lead to solvency issues. Below we outline a high level overview of some relevant legislation, signs to watch out for that an entity is at risk of insolvency, and steps to take now to protect yourself in the event of insolvencies in one of your contracting chains.

COVID-19 Safe harbour defence

Since 2017, directors in Australia have had the statutory protection of a safe harbour from liability for insolvent trading. On 25 March 2020, a new, temporary safe harbour from liability for insolvent trading was introduced in the context of the current COVID-19 pandemic. This applies to debts incurred by the company in the ordinary course of its business on or after 25 March 2020 and for a period of at least 6 months, that is until at least 24 September 2020.

To secure the benefit of the temporary COVID-19 safe harbour, directors must ensure that the debts are incurred in the 'ordinary course' of the company's business, which may be construed as debts that are necessary to facilitate the continuation of the business during the COVID-19 safe harbour period.

This would include, for example, a director taking out a loan to move some business operations online, and debts incurred through continuing to pay employees during the COVID-19 pandemic. Directors should follow the usual process of documenting all decisions to incur debts which may not clearly appear to be within the 'ordinary course' to assist them in being able to establish the COVID-19 safe harbour defence later, if necessary.

For more information on benefiting from the 2017 or COVID-19 safe harbour, see our article, COVID-19: Putting safe harbour in the spotlight.

Ipso facto

For contracts entered into after 1 July 2018 in Australia, the ipso facto reforms prevent a party from exercising a right under the contract which arises solely on the basis of the following insolvency events:

• appointment of a voluntary administrator;
• appointment of a receiver or managing controller over all or substantially all of a company's property;
• a company undertaking a scheme of arrangement for the purposes of avoiding being wound up in insolvency; or
• an event or circumstance relating to the affected party's financial position if an appointment or scheme of arrangement referred to in an earlier paragraph has been made or undertaken.

Rights which may be affected include the right to terminate, suspend, step-in, novate and, in some cases, call on security. A party retains its entitlement to enforce a contractual right for any other reason i.e. where the right does not arise solely as a result of one of the above events.

For example, if one of your counterparties becomes insolvent and the counterparty is in breach of its performance obligations, you will be able to exercise your rights under the contract in respect of those breaches. However, if one of your counterparties goes insolvent but has not breached any performance obligations and you do not have termination for convenience rights, you will not be able to terminate just because that party has gone insolvent, even if you expect that means they will breach performance obligations in future (if those breaches do occur, then you can exercise relevant rights).

There is a long list of exemptions to the statutory stay on exercising such rights in the Corporations Regulations 2001 (Cth) (Regulations). The Regulations provide for the types of contracts, agreements or arrangements that the stay does not apply to. For the construction and property industry, the key exemptions are those:

• involving a SPV that provides for a PPP or project finance;
• for defined building work, where the total payments are a minimum of $1 billion;
• involving Australia's national security, border protection or defence capability;
• for the supply of essential or critical goods or services, or for the carrying out of essential or critical works, to or for government, or to or for the public on behalf of government;
• for the supply of goods or services to, or on behalf of, a public hospital or public health service; and
• relating to government licences, permits or approvals.

For more information on the ipso facto regime and its particular impacts on the construction and properties industries, see our article, Ipso facto reforms have commenced - are you ready?.

Warning signs of contractor insolvency

Although a formal insolvency event can seemingly happen quickly, there are typically warning signs to look out for. While these, of course, do not necessarily mean that the entity in question is insolvent, they are at least an indication of liquidity and solvency risks.

In our experience, such signs include:

• Slowdown in performance of the works, project delays or lapsed deadlines
• Delayed payment of subcontractors or others within the supply chain, requests to the head contractor seeking direct payments from subcontractors, or increased use of reverse factoring
• Program and quality control issues
• Subcontractors refusing to attend site

Potential reason: Contractor doesn't have the cash to maintain sufficient project resource.

• Aggressive invoicing – requests for early payment from a contractor
• Lots of sudden claims across all of the entity’s/group’s projects
• Unusual financial borrowing, e.g. hybrid instruments
• Chasing new contracts to win

Potential reason: Trying to find ways to increase cash flow / reserves.

• Resignation of key personnel or significant loss of staff
• Increased financial oversight by head management or third parties

Potential reason: People responsible for loss removed from business or trying to find ways to increase cash flow

• Lack of communication or a delay in responding to questions

Potential reason: A lack of resources / usual sources of information tied up dealing with cash flow issues, or the entity not wanting to disclose issues to third parties

• For listed companies, profits warnings, short-selling by the market, or suspension of trading on ASX

Potential reason: Disclosure obligations from the entity and recognition of financial trouble by the market

Dealing with a potentially insolvent company

If a company that has an unsecured liability to you enters into a formal insolvency process and stops trading, then you should lodge a claim with the external administrator as an ordinary unsecured creditor to recover your money. Details of such a process will be provided by the external administrator.

Before any money is paid out to creditors, the external administrator will likely require a formal proof of debt to be lodged. This is a form to be signed by an authorised representative of the creditor attesting to the amount of the claim together with evidence of the debt.

If you are a supplier of goods in Australia and have a retention of title or similar clause in your supply contract, that interest needs to be registered as a security interest under the Personal Property Securities Act 2009 (Cth) (PPSA) to give you protection in the event that there is a failure to make payment of goods supplied so that you have a priority right as against the party's unsecured creditors and any other party which registers an interest over the goods.

This can have particularly detrimental consequences in the event that the party to which goods are supplied but not yet paid for enters into a formal insolvency process. In those circumstances, the interest can vest in the purchaser if:

• the interest is not registered within 20 business days of the interest being created; and
• the purchaser becomes insolvent within a six month period of the registration.

As a result, as a supplier you will have an unsecured claim in the external administration.

From a buyer's perspective, it is worth considering whether you want to include a clause in any supply or subcontract agreement contracting out of certain provisions of the PPSA in accordance with section 115.

There may also be other clauses in contracts such as retention monies clauses or other security clauses which, depending on the specific contractual drafting, may also need to be registered under the PPSA to give you the right to enforce them as a security interest in a formal insolvency context.

The ability and timing of when to call on any bank guarantees and apply any relevant set off clause against debts due in a contract will also need to be carefully considered in any insolvency risk scenario.

Bringing a claim against an insolvent company

If a company is in a formal insolvency process you cannot bring a claim against it without leave of the Court, and subject to such terms as may be imposed by the Court, unless you have the consent of the Administrator or Liquidator appointed. The proof of debt procedure is intended to replace such claims and be much more expeditious and less expensive than ordinary procedures. However, in certain circumstances there may be strategic reasons why proceedings may wish to be commenced and leave of the Court obtained.

When considering whether or not to grant leave to bring a claim, the things a Court will consider include:

• whether the claim has arguable merit;
• the amount and seriousness of the claim;
• the degree and complexity of the legal and factual issues;
• whether proceedings are already in motion at the time of the administration or liquidation and, if so, the stage to which proceedings have progressed;
• whether the proceedings are going to result in prejudice to general body of creditors in the administration or liquidation;
• the cost of the hearing in comparison to the company's remaining resources;
• whether the claim is a claim which could not be proved in the administration or liquidation;
• if the claim is a test case for the interest of a large class of potential claimants;
• if the company is insured against the relevant liability; and
• whether the grant of leave will unleash an avalanche of litigation.

Next steps for everyone

If you suspect that an entity within one of your project contracting chains might have solvency issues, there are a number of protectionary steps that you can consider. The first is to review your contractual rights and obligations relating to:

• suspension;
• termination;
• payment;
• security;
• unfixed goods and materials both on and off site;
• collateral warranties;
• step-in;
• intellectual property; and
• insurance.

Many of these must also be considered in the context of the ipso facto regime.

Suspension and termination

If there is an entity directly upstream that has insolvency risk, consider whether you can suspend work to prevent you from having to continue to perform work for which you might not get paid. If there are further upstream entities consider also whether you have rights to request payment directly from them in the event that your direct principal becomes insolvent or otherwise stops paying invoices.

If you have a downstream entity (e.g. subcontractor) that has some insolvency risk, consider your termination for convenience rights or if there are any other grounds for termination which must be carefully considered in the context of the ipso facto regime.

Payment

For contractors: make sure that all payment claims and other related notices have been submitted and, if there are further upstream entities consider whether you have rights to or may otherwise request payment directly from them in the event that your direct principal becomes insolvent or stops paying invoices. Exercise such rights as soon as possible before the entity enters into any formal insolvency process.

For principals: consider any payments made very carefully, and use any contractual set-off rights that you might have where possible to reduce the amount of cash going to an entity with solvency issues. Note also there is a statutory set-off regime that applies in certain insolvency processes to the exclusion of any contractual terms, which will allow you to set off amounts.

Security and unfixed goods and materials

In the event of insolvency, security will often be the best chance of recouping any amounts owing. Make sure you are aware of the triggers allowing you to call on any security that you hold, and be prepared to fight injunctions against calling.

If you are holding a parent company guarantee, consider the extent to which the solvency issues might be prevalent throughout the relevant group, affecting the weight of the PCG, and also consider whether in the circumstances, there is any opportunity to obtain a third party bank guarantee or other security.

If there are unfixed goods and materials, confirm what rights you have to them and any risks such as failure to register a security interest under the PPSA. Also consider any practical issues in enforcing those rights; for example are the goods overseas, are they stored in a third party location to which you have no access rights, might the entity have (rightly or wrongly) granted security over them to a third party by way of a general or specific security agreement, etc.?

Collateral warranties and step-in

Although often an obligation, it is common in practice for not all collateral warranties to be provided. If your contractor is obligated to provide collateral warranties or similar instruments from all of its subcontractors, ensure that you hold a properly executed copy of each. Without that direct contractual remedy against subcontractors, it will be much harder to have recourse against subcontractors in the event of contractor insolvency.

Insurance

Confirm that all the required insurances are in place, what they might cover in an insolvency situation and be aware of the steps you need to take to access the policy cover. In the event that the insolvency of an entity in your contractual chain causes you loss, having an insurance policy which responds will likely be the easiest way to recover.

Other possible steps

If you are a principal who is worried about the insolvency risk of a head contractor, make sure that you can secure the site, make it safe, and cover up the works as appropriate.

Principals and head contractors may also wish to do audits of the plant, equipment and other materials on site that you own or are responsible for, and which are under the control of an entity which has become insolvent / has insolvency risk, and generally track it more closely, in the event any of it is misplaced and not returned to its appropriate place or otherwise properly accounted for.

Finally, if there are JVs in your contracting chain or you are part of a JV, you should check what happens if the JV or just one JV party becomes insolvent. This will depend on whether or not (and if so, how) the JV is incorporated, the terms of the JV agreement, and the terms of any agreements that you have with the JV.

Contact us to find out more about the temporary COVID-19 safe harbour measures and other means to protect your exposure to parties at risk of insolvency.